International and Global

Inflation: base effects versus spare capacity

The prospect of inflation remains a hot topic for both investors and policy makers.
February 2021

The prospect of inflation remains a hot topic for both investors and policy makers. Chair Powell, in his testimony to Congress this month stressed that ‘inflation risks are to the downside’. He stated that inflation in the coming months is likely to jump as a result of ‘base effects.’ In other words, the annual change in inflation may print high because of abnormally low inflation a year earlier, after the onset of the pandemic. Beyond the base effects, current price pressures appear to be temporary. In the US, ISM Manufacturing Prices Paid increased to 82.1, its highest level since 2011. Manufacturers continue to be affected by surging commodity prices and supply chain bottlenecks for various inputs, most notably semiconductors. In Europe, inflation increased by 0.9% in January, the highest level since the pandemic and also the fastest jump in a decade. European manufacturers are dealing with significantly higher shipping costs as a result of a spike in the price of containers, which have more than quadrupled since the end of last year.

We maintain our view that current inflationary pressures are transitory in nature and sustained inflation will not emerge until the ample levels of spare capacity in the global economy are used up. That being said, as developed economies continue their vaccine led reopening, these transitory factors could boost inflation to levels we haven’t seen for many years. Earlier this month, Bundesbank President Jens Weidmann forecast inflation in Germany to rise above 3% in 2021. Furthermore, for financial markets in the short term, what is arguably more important than actual inflation in the real economy is market expectations of future inflation. This month the US 10-year Treasury yield hit a one year high of 1.55% and the US 10-Year breakeven inflation rate reached a 6 year high of 2.24%.

Signs of an uneven recovery

Looking at the progress of the economic recovery, the US kicked off 2021 with robust growth in consumer spending. Retail sales increased 5.3% from December to January, 7.4% higher than a year earlier. Households were buoyed by the passage of stimulus at the end of December, which included a second round of $600 stimulus cheques as well as enhanced unemployment insurance. Whilst there has been a lot of focus on the unequal distribution of income in the aftermath of the initial shock, recent data suggests that lower income households have contributed to the spending surge in January. Consumer spending among the lower income group was up 8% by the end of the month whilst spending among the high-income group contracted by -5.9%. Despite the brief rebound, US economic potential remains deeply scarred as a result of the initial shock. Much of the impetus behind additional fiscal stimulus has come from the current state of the labour market. Chair Powell importantly noted in his testimony that the current level of unemployment has ‘dramatically understated the deterioration in the labour market’. This is due to the fact that the labour force participation rate has experienced the largest 12-month decline since at least 1948. When counting the millions who have withdrawn from the labour force due to the pandemic, Powell argues that ‘true unemployment’ is closer to 10%.

The recovery in the Eurozone has been uneven. With lockdown measures still in place, the services sector has been crushed. The Markit Services PMI contracted again in February to 44.7. This has been partly offset by strength in the manufacturing sector which continues to benefit from external demand, particularly from China. The Manufacturing PMI hit a 3 year high of 57.7. Nevertheless, GDP data at the beginning of this month confirmed that the Eurozone experienced a double dip, with growth falling -0.7% in Q4 of last year after gaining 12.5% in Q3. Many have observed the excess savings that Eurozone households have built up over the last year and are banking on ‘pent-up demand’ to fuel growth once lockdowns come to an end. However, this will depend upon the level of precautionary savings that households choose to hold in the future. As it stands, unemployment expectations in Europe are higher than the actual unemployment rate, which has been propped up through the use of short-time work schemes. This suggests that households are likely to remain cautious until they feel more secure in regard to their long-term employment situation. 

With the exception of Spain, the UK suffered the sharpest contraction in GDP (-9.9%) in 2020 among the major economies. Yet, contrary to the Eurozone it avoided a double-dip recession with 1% growth in the fourth quarter of last year. Optimism seems to be building within the services sector, as the Markit PMI increased from 39.5 to 49.7 in February. Moreover, a successful vaccine rollout has so far curbed hospitalization rates and a partial lifting of restrictions is now expected at the beginning of April. With continued progress on the vaccine front, it seems the worst may be behind us here in the UK. The pound has appreciated as a result of this optimism, reaching a 3-year high against the dollar this month.

Reflation trade persists

The market focus for February was on rates as the rise in 10-year yields caught the attention. The move in yields is a corroboration by financial markets that an economic recovery is anticipated. Expectations of economic growth and corporate earnings estimates are picking up. Upbeat investor expectations have propelled equity and commodity prices sharply higher in recent months.

Bond yields have been driven down to historically low levels by massive buying programmes of central banks, in an attempt to support both markets and the economy. The move in equities over 2020 owed much to liquidity infusions and low bond yields. Little wonder that any pause or reversal of these trends ignites market volatility.
The rise in yields over the last three months has removed support for momentum stocks with pro-cyclical value stocks being more in favour. Financials, energy and travel stocks have been favoured over momentum stocks such as technology. Technology stocks are “long-duration” investments, that is earnings are weighted further out than most other stocks, meaning a higher yield reduces the present value of these earnings by a greater extent than a lower yield.

The rotation into cyclical sectors highlights the market’s belief that an end to the pandemic is in sight. It also highlights the belief that the rise in bond yields will not be rapid and will remain relatively contained. Both these views will be tested as the year progresses. One thing is clear, central banks are not looking to hike rates or subdue any inflationary pressures, particularly given the volatility generated by previous attempts to taper support. Inflation will help in devaluing the debt burden assumed by governments through the pandemic something of which central bankers are only too aware.

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